Letís get real about life insurance levels of cover
The amount of life insurance cover required and actually purchased will vary from person to person and is dependent upon their perception of risk, their attitude towards self-insurance, affordability and their personal priorities and fears.
Consider the following:
The level of cover is unlikely to be static over a person’s lifetime. You need more cover when your risks and responsibilities are greatest. For example, when you have a young family that is financially dependent upon you plus you have a huge mortgage, then clearly the amount of life cover required is huge. Conversely, once someone is retired or close to it, then typically their asset base is larger than in their early years, expenditure requirements may be lower, they are eligible for a pension, and there may be no mortgage. In these situations, it is usual to see people with a reduced level of life insurance cover.
Self-insurance is a legitimate tactic to consider. This is where you consciously decide to accept a degree of the risk of something occurring. However, a prudent person would discuss this with their financial adviser to identify the level of potential risk that they are contemplating taking on. For example, if you are at low risk of an accident, are genetically healthy and have lived a healthy lifestyle, then your statistical risk of prematurely dying may be lower than your neighbour.
There are two generic broad-brush approaches to identifying the level of life insurance one may need. Both approaches require identification of the debts that would need to be met, the cost of a funeral and any other identified expenditure. The first approach takes this value and uses the rationale that the surviving spouse and family have a fixed number of years after which they need to stand on their own financially. This approach may be used if it is assumed that the spouse may remarry or the kids are close to leaving home, the mortgage is close to being repaid and the spouse is able to go back to work. As an example, this approach may have identified that there is $300,000 of debt and cost that would need to be repaid upon the principal income earner’s death and that five years is the length of time until the spouse and family can stand financially on their own. Under this scenario, the amount of cover required may be 5 x $300,000 = $1.5m. The second approach assumes that the amount of life insurance required needs to be sufficiently large that if invested at a conservative rate, it will replace the income lost of the deceased. Let’s assume the principal income earner has an annual income of $80,000 and that the spouse does not work due to young children. The investment amount required to produce $80,000 per annum income assuming an earning rate of say 5% after fees but before tax would need to be around $1.8M assuming that the $80,000 was also required to keep pace with inflation plus an additional small lump sum was required to pay for the funeral and other expenses.
As can be seen, both approaches end up with large amounts of life insurance which fortunately, is very cheap when the life insured is young but becomes increasingly more expensive as one ages. Therefore, it is important to work with your financial adviser and regularly reassess the level of cover required as the risk lessens and your other assets increase.